What drives international equity correlations? Volatility or market direction?

We consider impulse response functions to study the impact of both return and volatility on the correlation between international equity markets. Using data on the US (as the reference country), Canada, the UK and France equity indices, empirical evidence shows that without taking into account the effect of return, there is an (asymmetric) effect of volatility on correlation. The volatility seems to have an impact on correlation especially during downturn periods. However, once we introduce the effect of return, the impact of volatility on correlation disappears. These observations suggest that, the relation between volatility and correlation is an association rather than a causality. The strong increase in the correlation is driven by the past of the return and the market direction rather than the volatility.

► We study the return and volatility effects on international equity correlations.
► US, Canada, UK and France equity market indices data are used.
► We find a spurious (asymmetric) effect of volatility on correlation.
► There is association between volatility and correlation, but not causality.
► A correlation increase is driven by market downturn rather than high volatility.